Arm Holdings: Is This An Attractive IPO?

Carter West joined discussion · Sep 7, 2023 18:30

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Arm Holdings IPO

Arm Holdings recently initiated an IPO process, and it is expected to go public later this year. Currently, Arm Holdings is owned by Softbank Group (OTCPK:SFTBY), which will be the seller of its shares. Arm Holdings itself will not sell any shares to the public, meaning that it won't generate any new cash - instead, the proceeds will ultimately flow to Softbank, which will be able to monetize its position in the UK chip company partially.

Company Overview

Arm Holdings has a staff of 5,963 full-time employees across North America, Europe, and Asia as of March 31, 2023. It is an engineering-first company, with around 80% of its global employees focused on research, design, and technical innovation. It has global operations and R&D centers in the UK, Europe, North America, India, and Asia-Pacific, with its headquarters located in Cambridge, UK. Arm uses a fabless business model, which means that it doesn't manufacture any chips itself. Other semiconductor companies operate similarly, relying on foundries such as Taiwan Semiconductor (TSM) for capital-intensive manufacturing.

Arm Holdings is best known for the ARM architecture that is widely used in different chips, including in the SOCs that Apple designs and uses, such as the A16 Bionic that is used in the current iPhone model or the M1 that is used in Apple's Macs. These designs are licensed to other companies by Arm Holdings, which receives compensation for doing so.

The company also designs its own chips, primarily CPUs, as well as GPUs and other products. For example, a recent product from Arm Holdings is the Immortalis-G715 GPU, which will be used in high-end smartphones for gaming and other graphics-intensive tasks.

Arm Holdings IPO Valuation

Although ARM architecture is widely used around the world, the payments flowing to Arm Holdings are not particularly high. There are currently billions of chips using ARM architecture in circulation, but Arm Holdings only generates a relatively small amount of revenue from them. The company estimates that its royalty revenue as of December 31, 2022 represented approximately 1.7% of the industry TAM containing Arm-based chips.

For the calendar year ended December 31, 2022,we estimate that our TAM was approximately $202.5 billionand we forecast that our TAM will grow at a 6.8%compound annual growth rate("CAGR") to approximately $246.6 billion by the end of the calendar year ending December 31, 2025. We estimate that the aggregate value ofchipscontaining Arm technology was approximately $98.9 billion in the calendar year ended December 31, 2022, representing an approximate 48.9% market share as compared to an approximate 42.3% market share as of December 31, 2020.We estimate that our royalty revenue as of December 31, 2022 represented approximately 1.7% of the industry TAM containing Arm-based chips.We expect that the cost and complexity of chip design will continue to increase, and that we will be able to contribute a greater proportion of the technology included in each chip, resulting in our royalties comprising a greater proportion of each chip's total value. Our calculation of TAM is based on a combination of third-party sources, customer reports and our own internal assessments and judgment.

Arm Holdings has a very high gross margin because a significant portion of its revenue comes from license fees, and its net profit is also quite attractive, at around 20%. However, this means that Arm Holdings' net profit last year "only" slightly exceeded $500 million. Considering this profit level, a market capitalization of $50 billion seems quite high to me because it is roughly equivalent to about 100 times its net profit. This valuation is much higher than that of companies like AMD and NVDA, whose expected profits are around 60 times their share prices.

Although Arm Holdings has strong technology and its intellectual property undoubtedly has significant value, ultimately, profitability determines its ability to return cash to shareholders. The company earns around $500 million in net profit each year and would need to maintain rapid growth over many years to justify a valuation of $60 billion or more.

Arm Holdings will soon go public, and although its profit margin and intellectual property are strong, its overall valuation of over $50 billion and each ADS priced at $47-51 should be cause for investors to consider the impact of buying shares at 100 times or higher P/E ratios. Even if the company maintains its impressive growth over the years, attractive total returns to shareholders are not guaranteed. In fact, when people buy stocks at such high valuations, even if the underlying business growth remains attractive, share prices may still be compressed.

Therefore, personally, I believe that if Arm Holdings really goes public at such a high valuation, the stock price will be too expensive, and I wouldn't plan to buy shares after the IPO unless the stock price falls significantly.